• CIO Outlook
• May, 2012

Barely two months after it looked as if the global economy might get a reprieve, the risk of contagion from Greece may be unavoidable. As we wrote back in March, the troika (the European Central Bank (ECB), the International Monetary Fund (IMF) and European Union (EU) Finance Ministers) said to investors "don't worry, we got this one." And so March 20th passed with the bang from the default in Greece being muffled by the excess liquidity provided by the ECB and the debt swap arranged via the troika. In retrospect, the bang may have been the proverbial bell tolling, signaling worse was yet to come. A round of elections has come and gone, another Greek government has collapsed and the Greeks now have a provisional government until another round of elections takes place in mid-June. In the interim, a new French president has already begun to distance his country's views from those of Germany, opening a gap in a once-tight relationship that dealt with Europe's issues as a united front.

Recent polls in Greece suggest the parties are in a dead heat, and the outcome remains very much in doubt.

In her recent report "The Ties that Bind," London-based BofA Merrill Lynch Global Research economist Laurence Boone is hopeful the political process in Greece will ultimately produce a more moderate government led by the New Democracy coalition and not the anti-austerity that a decisive Syriza victory would bring. However, recent polls suggest the two parties are in a dead heat, and the outcome remains very much in doubt. Either the New Democracy coalition wins, in which case it's likely: [1] Greece stays in the Eurozone for now; [2] the ECB and the troika keep Greece's funding lines open and [3] the muddle-through political atmosphere prevails until a longer-term solution to Greek debts (including, potentially, a managed exit from the Eurozone) is devised; or Syriza wins, and it's quite likely: [1] the new government rejects the troika's austerity regime; [2] the ECB cuts off funding to Greek banks and [3] Greece's economy collapses, mass deposit flight ensues and Greece makes a disorderly exit from the Eurozone. Either way, a euro sell-off against the dollar seems likely amid a flight to safety which only grows more pronounced in the wake of the second scenario. That's why, with just weeks remaining in this latest act, and despite the deep discounts being seen in key assets, we see little reason for investors to move back into European markets and prefer to wait on the sidelines until there's more clarity about which of the either/or scenarios we're really dealing with here.

After the unsuccessful Greek bailouts and troika threats in the past few years, one lens through which to view the situation in Europe is game theory. A classic illustration of game theory is the Prisoner's Dilemma. In the game, two prisoners arrested in connection with the same crime are held in separate cells and must decide whether to betray one another in return for a reduced sentence or to keep quiet and thereby deprive the police of key evidence they may need to make their case. In the most basic version of the game, there are exactly four possible outcomes: [1] prisoner A and prisoner B both squeal on their accomplice; [2] A squeals and B stonewalls the authorities; [3] A stonewalls and B squeals and [4] A and B both stonewall. Note that in only one of the four scenarios would a prisoner actually be better off trusting his accomplice and keeping his mouth shut. That's why if each player in the game is purely motivated by self-interest, typically he will proceed immediately to sell his compadre down the river.

The troika and Greece look to be playing a version of the Prisoner Game according to the basic human script — every man for himself.

From where we sit, the troika (backed by Germany) and Greece look to be playing a version of the Prisoner Game according to the basic human script — every man for himself. The troika seems to have decided that there are four possible scenarios — [1] the troika remains steadfast in its demands for austerity and Greece steadfastly rejects those demands; [2] the troika bends and Greece remains steadfast; [3] the troika remains steadfast and Greece bends; and [4] the troika and Greece both bend — and in only one of the four does it gain anything from compromising now. So why risk it? Greece seems to be applying similar logic. Better to play the odds, and reject, reject, reject, and at least gain some control over the timing and duration of its own destruction. But we'd argue that, in fact, the two sides aren't actually playing the game the way it should be played at all. Whether the troika gives into some of Greece's demands and prints enough euros to cover Greek and other peripheral country debts, or whether Greece defaults and the troika prints enough euros to stanch the contagion in the rest of Europe — in either case it's printing euros! And chances are it prints a lot less if it gives itself enough time to manage the whole mess in an orderly and more coordinated fashion.

There's also another reason classic game theory breaks down in a true analysis of the Greek crisis. In the Prisoner Game, the two players are prevented by thick cellblock walls from communicating with one another. In the real world of European politics, the players can communicate all the way up to the decision. So, why then, is there no compromise if both sides would benefit from gaining more time?

Of course, the troika and Greece aren't the only ones playing games these days. Greece hasn't even fallen yet and suddenly the troika finds itself engaged in a similar dynamic with Spain and Italy. Will it learn its lessons from the Greek tragedy and enter quickly into negotiations to ease the pressure on Spanish and Italian banks, or in an attempt to drive a harder bargain will it tempt fate with banking systems and economies many times the size of the ones in Greece? And what of the United States? If and when more euros have finally been printed in Europe, the longer-term issue will be how the stock of debt in Europe and the U.S. can be reduced. In the U.S., debt has been such an essential driver of economic growth over the past 30 years that it has been difficult for most economists to see any solution other than to attempt to cure the current debt problem with more debt (because they misframe the problem as a lack of growth, rather than too much debt). But this approach to debt repayment is illogical as a permanent solution and in the end requires ever more economic growth to service it. Austerity alone is not the answer either, as Greece has shown. The fact is, as with Greece and the Eurozone, there are fewer and fewer financial and economic paths open to the U.S. the longer there is no political compromise.

It doesn't take a degree in game theory to understand it would be far better for politicians in Washington to derive a compromise soon on deficits, jobs and taxes.

To move forward then, the U.S. and Europe need to address what is lacking in current political climate: a culture of compromise. Conventional wisdom holds that today's partisan American politics are merely a reflection of the underlying views of the populace and the duly elected leaders fulfilling their constituents' wishes. However, fulfilling representative obligations in a literal way does not preclude compromise. In our view, current U.S. politics, like in Europe, are based on each side believing they (or their constituents) will be less worse off if they betray their counterpart. Only in this real-life game, the constituents do suffer from each side betraying the other, because unlike a Prisoner's Dilemma thought experiment, the U.S. deficit deliberations will be subject to another round of federal debt ceiling negotiations this year, potentially as early as September according to BofA Merrill Lynch Global Research Senior Economist Ethan Harris. It doesn't take an advanced degree in game theory to understand it would be far better for politicians to derive a compromise soon on deficit reduction, jobs creation and increased taxation instead of allowing a third party like a ratings agency to intervene in the game and impose a new set of rules at summer's end.

We highlighted in last month's Outlook our concerns over the dependency on government sponsored income, credit and liquidity to support markets. To it, we add the necessity of political compromise. While we have made no changes in our recommended portfolio positioning since last month (we still favor more defensive income-producing themes, much as we have since early 2011), we are growing more concerned that the policy response from central banks, when it does come, will need to be drastic (game-changing even) to account for all the time politicians have spent believing the only way forward was to make the other side lose. In our view, the uncertainty over political actions still warrants a very broadly diversified portfolio that includes a number of strategies that explicitly manage risk, such as those that use derivatives or Market-Linked Investments; adding foreign currency exposure to capture the opportunity created by central banks responding to political crises; and redeploying existing hedge fund portfolios toward strategies with less direct market exposure. Within the equity part of portfolios, we believe investors should focus on specific sectors like technology, industrials and energy, as well as individual companies that are buying back their shares. In fixed income, given the likely forthcoming tax increases, we maintain the focus on municipals but complement it with mortgage and corporate bond exposure.

While the grooves in our record are well worn, the bottom line is simple: there is still far too much debt in the economic system and no credible plans to reduce it to warrant full risk-on positions. The factors we listed in March as signs for a more positive view on risk assets in the long term — the ongoing improvement in the jobs data and an improving housing market — remain, and to those we add signs of compromise in Washington. These signs among others would suggest economic growth is moving at a fast enough pace to provide flexibility to policymakers when devising long-term solutions to our country's debt and deficit woes. In our view, Congress's lack of action on jobs, the deficit and taxation amounts to purposeful neglect of the issues, when what we need is a game theory built for the real world.